Real estate: ten myths

01. August, 2008

I always tried to avoid talking about real estate because it tends to make people aggressive. However, I am increasingly irritated by what seems to be an infinitely elastic supply of opinions from countless real estate experts. I am no expert in real estate myself, but a lot of what the experts say does not make much economic sense. Thus, I'll take my chances and try to compile a list of real estate myths (in no particular order). Suggestions to the list are welcome.

Myth #1: Real estate prices cannot fall

No comments. But note that this is what many of today’s ‘experts’ were saying couple of years ago.

Myth #2: Prices cannot drop below construction costs

Yes, they can. Thinking in terms of historic costs can be very misleading. Construction costs matter at the stage when a builder decides whether to build a house or not. Once the house is built, however, costs incurred in the past are irrelevant. What matters are opportunity costs, i.e. the benefits foregone by not selling property at a lower price. For example, even for someone who built a house using his ‘own’ money, the opportunity cost of not selling at a lower price is revenue foregone from investing sales proceeds in some other asset. It is true that it is very unlikely for real estate prices to stay below construction costs for a long time. Yet what difference does it make to a builder who can’t sell at a desired price but has to pay interest on his bank loan, taxes, and other business expenses? If one can’t make a profit, the least one can do is to minimize losses.

Myth #3: The price of real estate should be 100*X per square meter (or any other formula)

There is no scientific way to establish what the price of real estate (or any other price) should be. Market price is the result of supply meeting demand, that is, competition between buyers and sellers of real estate. There are some important factors that are hard to quantify, such as preferences and security of future income. Economists usually look at information about past prices. In case of Latvia, however, such information is not reliable. Real estate prices during a bubble cannot tell us much about what will happen after the bubble (except that prices will fall). Information on prices before the boom is not very useful either because there was a serious liquidity constraint (not many had access to mortgage). Even construction costs are not very informative because they were inflated by the real estate boom. Clearly, one of the effects of a bursting bubble will be fall in wages in the construction sector, which will reduce the cost of building new homes. The bottom line is that real estate prices have to be sorted out by the market forces, i.e. sellers and buyers. But this may take a few years.

Myth #4: If only the ‘VID izzina’ were gone…

Advocates if this myth blame collapse of the real estate market on the government’s anti-inflation plan, especially the need to obtain proof of income origin (‘VID izzina’) from the tax authority. I wonder, however, whether the anti-inflation plan really had much of an effect. The banks themselves began to tighten lending because too many red lights were flashing. The anti-inflation plan may simply have provided a good excuse for doing what they would do anyway. Take Estonia, for example. To the best of my knowledge, the Estonian government did not make household credit conditional on any documents from the tax authority. Yet the same thing has happened. The banks tightened lending. Borrowers began to come to their senses.

Myth #5: Prices can’t fall much further because owners can rent, rather than sell residential property

This myth has already been mostly debunked, but still… A popular belief some time ago was that prices can’t fall because owners can rent out their premises. That’s not true. An increase in the supply of apartments for rent will drive down the rent itself, which will make the renting less attractive relative to selling. Thus, we’re back to square one. And that’s what we see, rents are falling.

Myth #6: Prices will rise soon because the average per capita living area in Latvia is only half of the European average

At first glance that one is hard to disagree with. If Latvia is to catch up with the EU, there has to be some convergence. The real question, however, is how long this convergence will take. An important determinant of demand for real estate is wealth, eg having some other real estate. My guess is that most real estate transactions are ‘upgrades’, when people sell their old homes to afford a better one. This implies that many families increase their living area incrementally, i.e. by ‘upgrading’. For this, a family needs a home to sell. Since homes are typically inherited, this means that somebody has to die. What I am trying to say is that incremental increases in living area implies generations-long cycles. Generations take time to change, so the convergences can take quite a while. There is really no need for prices to rise substantially in the process.

Myth #7: Some segments of the market will be untouched

I seriously doubt it. From the demand side, there are always substitutes. An apartment in ‘Purvciems’ is a substitute for an apartment in ‘Teika’. An apartment in ‘Teika’ is a substitute for a private house. Etcetera, etcetera. No seller can price his product without into account that buyers have other choices. Further, as it was already mentioned, many transactions are upgrades, when a buyer sells his old home to buy a new one. The buyer’s willingness to pay for a new home will depend on the price he can fetch on his old one. Thus, it’s all inter-connected like one giant row of dominos. If one falls, so will the others.

Myth #8: But price of land definitely cannot fall

See Myth #7. Demand for land is derived from demand for real estate. Falling real estate prices will also cause a fall in the price of land.

Myth #9: Hurry, because soon the foreigners (eg Russians, Arab sheiks) will buy it all

That one is my favorite. It’s probably one of the products of a ‘narrow identity’, especially popular with those who never set their foot outside Latvia. Personally, I just don’t understand why Westerners would want to live in Latvia unless they work for embassies, have a love interest here, or there are some exceptional circumstances. Then there are those nostalgic oil-rich ‘Russians’. I can buy the argument that some of them may want a ‘safe haven’ in Russian-speaking Latvia. Yet I have a feeling that younger generations of Russian elite speak fluent English and don’t share their parents’ sentiments about Jurmala. To them, weather in Spain (or Bulgaria) is much more attractive.

Myth #10: In the long run real estate prices will certainly rise, so it’s definitely a good investment

Another one that’s seems hard to disagree with. In the long run, I am quite optimistic about this country. Incomes will grow and people will want bigger and better homes, right? And yet here is why real estate prices may stay depressed even in the medium term. I am talking about demographics, of course. Many remember that the early and middle 90s were so bad that most people preferred not to have children. Just to give you an idea of what’s coming, the number of kinder-gardens in late 1990s was only half of what it was in late 1980s. Universities, for example, are the next to be hit as the number of potential students will dwindle over the next few years. And then the real estate market’s turn will come. In some 7-10 years time the number of new families looking for homes will drop substantially. Guess what effect on real estate prices this will have?

In Latvian here raksts

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